Chapter 10

17. Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which
of the following statements is most correct?
a. The after-tax cost of debt is generally cheaper than the after-tax cost of equity. *
b. Since retained earnings are readily available, the cost of retained earnings is
generally lower than the cost of debt.
c. The after-tax cost of debt is generally more expensive than the before-tax cost of
debt.
d. Statements a and c are correct.

18. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate
the cost of equity capital. The company’s capital structure consists of common stock,
preferred stock, and debt. Which of the following events will reduce the company’s
WACC?
a. A reduction in the market risk premium. *
b. An increase in the flotation costs associated with issuing new common stock.
c. An increase in the company’s beta.
d. An increase in expected inflation.

Statement a is true; the other statements are false. If RPM

decreases, the cost of equity will be reduced. Answers b through e
will all increase the company’s WACC.

19. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The
financial manager is evaluating a project with an expected return of 21 percent,
before any risk adjustment. The risk-free rate is 10 percent, and the required rate of
return on the market is 16 percent. The project being evaluated is riskier than Boe’s
average project, in terms of both beta risk and total risk. Which of the following
statements is most correct?
a. The project should be accepted since its expected return (before risk adjustment)
is greater than its required return.
b. The project should be rejected since its expected return (before risk adjustment) is
less than its required return.
c. The accept/reject decision depends on the risk-adjustment policy of the firm. If
the firm’s policy were to reduce a riskier-than-average project’s expected return
by 1 percentage point, then the project should be accepted. *
d. Riskier-than-average projects should have their expected returns increased to
reflect their added riskiness. Clearly, this would make the project acceptable
regardless of the amount of the adjustment.

ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19%.

Expected return = 21%. 21% - Risk adjustment 1% = 20%.
Risk-adjusted return = 20% > ks = 19%. Thus, the project should be
selected.

20. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100
percent equity financed. Division A’s cost of equity capital is 9.8 percent, while